Sunday, February 5, 2012

Apple's iterative approach to FRAND abuse is not for the faint of heart, but there's no better alternative

"Ladies and Gentlemen, this is your captain speaking. We are flying through an area of turbulence. Please return to your seats and fasten your seatbelts."

That's what Captain Cook (Tim Cook, not James) could tell Apple's stakeholders (employees, shareholders, customers, partners) in light of what happened in Germany on Friday and might reoccur soon: the temporary removal of products (or, in the future, product and service features) as a result of patent assertions by Android device makers in retaliation for Apple's IP enforcement. He probably won't make a statement like that, at least not until the going gets rougher and demands for explanations get louder.

As an independent analyst, I analyze court documents and the statements made at court hearings and trials. On this basis, I believe that Apple is absolutely on the right track. At this stage, there's no indication that Apple stakeholders have to panic. Apple stakeholders should panic only if (I repeat, if) Apple bows to the threat of FRAND abuse and gives up the level of intellectual property protection without which its business model won't work as well as it currently does.

People better prepare for further shockwaves of the kind we learned about on Friday, with the epicenter being in Germany most of the time, if not all of the time. In the near term, Motorola's lawsuits are most likely going to be the cause, but Samsung may at some point also hold enforceable injunctions against Apple in its hands.

As a follow-up to this Frantic Friday, I have analyzed court documents from the United States (where I found out about Motorola's 2.25% royalty demand) as well as Germany. There can be no doubt that Apple's approach to the problem is iterative: I have found evidence of several different proposals that Apple made to Motorola Mobility for taking a license to its standard-essential patents. Apple keeps amending its proposals, but it needs the courts to speak out on them, and whenever a court disagrees, there's a risk (depending on the stage of proceeding) of a ban being ordered or enforced.

The temporary removal of products from Apple's online store was simply the result of previous Apple offers having been deemed insufficient, and whether the ban enters into force again depends on an appeals court's evaluation (expected within a matter of weeks) of yet another amended offer.

That is, by the way, how Samsung is dealing with Apple's design-related rights: after an injunction in Germany, it launched a modified version of the Galaxy Tab 10.1, the 10.1N, and Apple also asked a German court to ban that one. The decision will come down on Thursday (February 9, 2012). At the time I already said that Samsung "wouldn't have launched the 10.1N if they didn't see a decent chance of this one being approved by the court, but if it takes them yet another iteration (or more than one) to get to the point of legal certainty, it's worth it with a view to future product generations". Samsung has to go through this process -- however painful, costly and nerve-wracking it may be -- because it's the only way to identify the sweet spot at which the courts will let them get away with products that look as similar as possible to Apple's offerings but aren't banned. Such a ban happened once and could happen again, but that's the price Samsung has to pay for optimization.

I'll now explain Samsung's and Motorola's strategy against Apple and then Apple's iterative strategy (with temporary bans being part of the calculated risk Apple is taking) as well as the basics of German case law on standards-essential patents.

Samsung and Motorola are pursuing the very same strategy against Apple, presumably devised by the same external lawyers:

When Apple reminded them of their own public pledges (as a precondition for getting seats at standard-setting tables) to grant licenses to their standard-essential patents on FRAND terms, Samsung demanded 2.4% and Motorola 2.25% of Apple's sales.

For reasons I'll explain further below, Apple cannot possibly accept those royalty rates -- which is exactly why Samsung and Motorola ask for them in the first place.

Based on Apple's refusal to accept those prohibitive terms, Samsung and Motorola are seeking injunctive relief against Apple. Motorola is doing so in the United States and Germany; Samsung is doing it in those two countries plus seven others.

Germany, a jurisdiction in which injunctions based on standard-essential patents are available in many scenarios in which the courts in other large markets would deny them, is a key battlefield for both Samsung and Motorola.

They hope that the disruptive impact of such injunctions on Apple's business will force Apple to grant them a license to all of its non-standards-related patents (such as its multitouch inventions) as part of a broader settlement. In other words, they want to use FRAND patents to reach a state of "mutually assured destruction", in which the notion of intellectual property would become meaningless between large players that have a critical mass of patents (it would merely serve to exclude new entrants without large patent portfolios).

Whenever Apple makes a proposal to those companies for taking a license to their standard-essential patents (which is what Apple has to do under German law), they will certainly find not only a fly in the ointment but a whole laundry list of things to grouse about. For example, at a Mannheim hearing on Friday, Judge Andreas Voss noted that Motorola still raised nine different objections against Apple's most recent proposal.

Samsung and Motorola are additionally asserting non-standards-related patents against Apple. Motorola just won a German ruling based on one such patent. But they probably don't expect those patents to be the fundamental threat to Apple's business that injunctions based on standard-essential patents represent. You can temporarily switch from push email to periodic pulls, but you can't sell a phone that can't connect with the mobile networks.

Apple can't simply pay 2.4% to Samsung and 2.25% to Motorola -- or 4.65% in total among the two -- in order to deprive its two main rivals of their potentially lethal weapon while continuing its own IP enforcement against those companies forever (or until there's a settlement that Apple agrees to without the threat of injunctions over standard-essential patents).

The problem is that those are only two out of numerous companies that hold standard-essential patents. The IPR database of ETSI, a major telecommunications standard-setting organization, contains declarations of essential patents from 175 different companies. While many of those hold fewer -- or even far fewer -- standard-related patents than Samsung and Motorola, the total cost of licensing patents essential to wireless telecommunications standards (GSM, UMTS, 4G etc.) would likely amount to anywhere between 20% and 50% (those percentages are rough estimates on my part) of Apple's sales. However, there are also some other industry standards, such as WiFI (WLAN) and video codecs. If there's no ceiling for the aggregate cost of licensing standards-essential patents, it could even exceed 100% of a company's sales. And that would still be prior to the cost of licensing patents that are not subject to any FRAND rules...

It's not just the percentages but also the royalty base that Apple can't accept. Both Samsung and Motorola want to be paid based on the entire market value of Apple's products. However, their patents on wireless communications patents cover features that are implemented by baseband chips, which typically cost between $10 and $15 per unit and come with a license to most (if not all) of the relevant patents.

As far as Samsung and Motorola are concerned, paying them their outrageous fees while suing one iOS-style feature after the other out of their products might look like a profitable deal on the bottom line -- but not if one considers the implications I just described.

Alternatively, one might think that Apple should just try to settle those disputes now, like it ultimately settled with Nokia. Even though cross-license agreements are going to be the end game, the question is on which monetary and (even more importantly) non-monetary terms those deals will be struck.

Whenever any of these disputes settle, there will probably a lot of speculation about which company ends up being the net payer, and how much it ends up paying. The amounts may very well be staggering, but for Apple's strategic purposes, the restrictions it can impose are going to be more valuable. An unrestricted license to all of Apple's patents for $40 per Android device -- in other words, allowing the Android ecosystem to commoditize Apple's business all the way through unfettered "copytition" -- would be much less attractive to Apple than selling a license for $10 if it comes with important restrictions, allowing licensees like Samsung and Motorola (or Google) to use only some Apple patents for any purpose, a second group of patents only for certain purposes (such as only on certain types of devices), and reserving a third group of patents exclusively for Apple in order to ensure differentiation.

A deal that takes care of Apple's strategic needs won't happen as long as Samsung and Motorola (or Google) try to use their standard-essential, FRAND-pledged, patents as strategic weapons in order to force Apple to relinquish all of its intellectual property.

Apple won't get a deal that meets its needs unless Samsung and Motorola (or Google) are forced to recognize the fundamentally greater strategic and commercial value of Apple's non-standards-related patents, which are the fruit of independent innovation and independent commercialization as opposed to a company's ability to push its patented ideas into industry standards everyone is forced to implement after a collective of major industry players defines them.

Samsung and Motorola (or Google) would like all patents to be treated in more or less the same way. They give nothing more than lip service to their FRAND licensing obligations. They may hope that the law on this isn't sufficiently settled in major jurisdictions. They look for loopholes in the rules -- including certain opportunities in Germany, where the case law on this is more favorable to them than elsewhere. If they realize at some point that this strategy doesn't work out because of a combination of court rulings, regulatory intervention and Apple's determination to stand its ground, then -- and only then -- Apple will ultimately get the kind of deal it wants. Until then, Apple doesn't even have much to talk about with Samsung and Motorola (or Google).

In the Orange-Book-Standard case (the ruling, dated May 9, 2009, is available here, in German), the German Federal Court of Justice held that a patent holder's refusal to enter into a license agreement on FRAND terms can prevent an injunction from being granted, but it takes more than a patent holder demanding unFRANDly terms: instead, the burden is on the defendant, who has to attempt to procure a license on FRAND terms by making a FRAND proposal and honoring it as if it were in effect. According to Orange-Book-Standard, a holder of standard-essential patents violates antitrust law to the extent that an injunction becomes unavailable only by refusing a FRAND offer from the would-be licensee.

Not only does the would-be licensee have to make such an offer but, as I said before, he also has to honor it, either by making actual payments or by posting a bond that would cover them (in order to eliminate the risk of the patent holder not getting paid due to the licensee's potential bankruptcy).

On the basis of Orange-Book-Standard, Samsung and Motorola would not even have had to offer any license terms to Apple, or they could alternatively have asked for even higher royalty rates, without compromising their ability to seek injunctive relief. There are three reasons for which they nevertheless made their (prohibitive) offers:

There are other jurisdictions than Germany.

Even the German Federal Court of Justice can ultimately be overruled by the Court of Justice of the EU. If the EU court determined at some point that seeking injunctions after making unFRANDly, prohibitive offers constitutes an antitrust violation, Orange-Book-Standard would be history. While that won't happen during the period that matters to Samsung and Motorola with respect to their current quest for injunctions, they at least want to make offers with which they can try to defend themselves against antitrust allegations. Samsung, in fact, is already being investigated by the European Commission, which may find a violation of EU antitrust rules even if German case law would have allowed the same conduct.

Even though Samsung and Motorola deny that their own FRAND pledges are legally binding (something that they actually have asserted in their defense against other FRAND patent holders), they can't rely on this being the finding of the final judges.

Orange-Book-Standard has a number of negative effects. It's utterly unbalanced to the benefit of patent holders, setting an incredibly high bar for an antitrust violation. It's quite possible that the European Commission has recognized this and now tries to use its different means (through competition enforcement at this stage, and possibly a legislative proposal at the European level further down the road) to ensure that patent holders will nevertheless have to honor their FRAND commitments.

Under a more reasonable framework than Orange-Book-Standard, defendants could prevent an injunction from coming down by finding just one important shortcoming in a license offer. For example, a Dutch court denied Samsung an injunction against various Apple products because its 2.4% royalty demand was totally out of the FRAND ballpark.

By contrast, Orange-Book-Standard gives patent holders countless opportunities to claim that they are in their right to reject a proposal from a would-be licensee. They need to find only one such persuasive reason for this, and they win (or get to enforce) an injunction.

At the court hearing on Friday, MMI's lead counsel in the German litigations once asked the judge, after pointing out what he considered a shortcoming of Apple's proposal: "What advice should I give to my client?" He meant to say: "You can't force my client to accept this".

In a normal licensing situation ("normal" in the sense of everyone being free to negotiate without an absolute need to come to an agreement), any of the points MMI's counsel raised could also come up. He certainly went out of his way to identify as many shortcomings as possible, but frankly, any lawyer who wants to be totally protective of his client's interests might have raised the same issues even without MMI presumably having told him to do everything he can to win an injunction. I've seen it happen in negotiations. The difference, however, would be that the other party -- Apple -- wouldn't be under pressure to procure a license.

On the surface, Apple is negotiating with MMI (or would be negotiating with Samsung, but since Samsung hasn't even won any ruling based on the merits of its patents, they're not there yet). But in practical terms, since MMI doesn't want to reach an agreement (it wants to win and enforce injunctions for the reasons explained further above), Apple is presenting its proposals to find out what the judges will say.

Once the courts say that Apple has met the Orange-Book-Standard requirements in order for MMI to be guilty of abusive conduct under German case law, Apple has won and MMI can't win or enforce any more injunctions based on standard-essential patents against Apple in Germany.

The issue in this iterative process is not that they have to agree on a particular percentage for future royalties. Under Orange-Book-Standard, a would-be licensee can either offer a particular royalty rate or can leave this determination to the courts (technically, the patent holder is then free to determine the amount in his reasonable discretion, but subject to judicial review and, if necessary, adjustment). Leaving the exact royalty amount open is the path Apple has, not surprisingly, chosen.

The Mannheim court also indicated that Apple doesn't necessarily have to take a license to all of MMI's standard-essential patents at the same time, or on a worldwide basis.

There is, however, still quite some disagreement on various terms that will influence how much Apple will ultimately have to pay for future use as well as past infringement of MMI's standard-essential patents. There is so much at stake here, not only between Apple and MMI but also with a view to other patent holders Apple will have to do deals with, that it makes sense for Apple to take certain risks of temporary product bans in order to find out just how far-reaching its concessions have to be.

In order for Apple to find out how the judges view its different proposals, it needs procedural opportunities. It can't go the court with a new proposal every day. Apple can send proposals to MMI anytime, but the courts will only review them from an Orange-Book-Standard point of view if MMI seeks a new injunction (there's no shortage of German Motorola v. Apple litigations according to the table contained in this recent post), defends one in an appellate proceeding, or seeks enforcement, which Apple can then move to be suspended.

For Apple, it would obviously be preferable to have clarity and to win favorable decisions before an injunction comes down. But as everyone could see on Friday, the process doesn't end there. A failure by MMI to honor its obligations under antitrust law can also be alleged whenever Apple opposes enforcement, such as by asking for a suspension of enforcement.

The problem with trying new proposals at the enforcement stage is, however, that Apple must honor the relevant injunction unless the court suspends enforcement for at least some time.

Those turbulences are inevitable. Without them, Apple can't get the clarification it needs.

Information on Apple's various offers is contained in the Mannheim Regional Court's December 9, 2011 ruling and the Karlsruhe Higher Regional Court's January 23, 2012 order denying Apple's first motion to suspend enforcement (they're now evaluating the second one and have suspended enforcement, for the time being, only until they decide on the second motion, which can result either in continued enforcement or a suspension until the end of the appeals proceeding). I furthermore obtained information by following trials. I attended a trial in early December involving a different Motorola patent but the same Orange-Book-Standard issues at the heart of the December 9 ruling, and another trial on Friday (involving the same standard-essential patent, but with Apple Inc., not its European distribution organization, being the defendant).

Here are the key milestones:

On August 6, 2007, Motorola told Apple that it needed to take a license.

I don't know when Motorola made its 2.25% royalty demand. The letter in which it was mentioned has an October 2011 date but doesn't specify when Motorola made that demand. Whatever the date of that demand may be, Motorola may or may not have made other demands prior to the 2.25% one, though they may also have had a consistent position over an extended period of time.

On October 4, 2011, Apple made its first proposal to MMI -- 17 days prior to the first Mannheim trial involving an MMI FRAND patent (to put this into perspective, one week before trial is the cut-off date for new facts in German litigations).

The Mannheim Regional Court held (on December 9, 2011) that MMI rightfully rejected this proposal because Apple wanted to keep the door open to challenge the validity of the patent-in-suit with a view to MMI's claims for past infringement.

The Mannheim court acknowledged that there were different opinions in the German legal community as to whether a license agreement would have to include a recognition of liability for past infringement, but decided that a patent holder wouldn't have to grant a license going forward without having clarified the question of liability for past infringement.

The Mannheim court particularly didn't want to allow a challenge to the validity of the patent in connection with past damages because otherwise there could be scenarios in which someone refusing to take a license (until he gets sued) could ultimately pay less than someone who takes a license. To be precise, a nullity action against the patent would always be possible, but the patent holder would then, in the Mannheim opinion, have to be free to terminate the license agreement, which can have dramatic consequences in connection with a standard-essential patent.

The fundamental problem with that approach is that the Mannheim court is not at all concerned about the possibility of royalties being paid for the use of a patent that should never have been granted in the first place -- and many patents are invalid as granted. That unbalanced approach further exacerbates the problems posed by Orange-Book-Standard. It's a line of thought that gives the holders of standard-essential patents pretty much the same rights as holders of other patents, without concern for the major problems this creates for implementers of standards. MMI took advantage of this to win the December 9, 2011 decision.

At the time, MMI had raised a whole list of other objections. But the December 9, 2011 ruling didn't rule on the rest of them because it wouldn't have been outcome-determinative after one legitimate reason for MMI's rejection of Apple's proposal had been identified.

If the Mannheim court had nevertheless taken a position on MMI's other objections, Apple would have been much wiser, but since that didn't happen, Apple now needs to find out by other means what requirements the courts (especially the appeals court) establish before MMI is forced to accept Apple's proposal.

On December 14, 2011, Apple appealed the December 9 ruling to the Karlsruher Higher Regional Court and, simultaneously, moved to suspend the enforcement of the injunction.

At this stage, Apple presented two amended proposals: one that was submitted to MMI on November 10, 2011 (that's presumably the one that was discussed at the December 2 trial involving a different patent), and yet another one that was further amended and submitted on December 14 (the date of the appellate brief).

The November 10 proposal said that Apple would withdraw all pending challenges to the validity of the patent, but clarified that Apple wanted to reserve the right to challenge the validity of the patent only for a scenario in which MMI seeks damages above a FRAND royalty rate, and that its obligations for future royalties would not be affected by a potential invalidation of the patent.

The December 14 proposal no longer mentioned the possibility of nullity actions in the event of MMI seeking damages in excess of a FRAND royalty level. Another proposal was made on January 5, 2012, but there was no change with respect to that particular clause.

On this basis, the Karlsruhe Higher Regional Court denied Apple's first motion to suspend enforcement. The appeals court held that MMI didn't have to accept a proposal that wouldn't allow it to terminate the agreement in the event of a future challenge to the validity of a licensed patent, given that this is, in the court's opinion, a common clause in patent license agreements. The appeals court thought that MMI can insistent on being able to terminate the agreement in such an event without committing an antitrust violation by rejecting a reasonable and non-discriminatory proposal.

As a result, MMI was again free to enforce, and Apple had to remove certain products from its German online store.

The date of Apple's second motion to suspend enforcement is unknown. It must have been filed at some point between the January 23 denial of the first motion and the February 3 decision to suspend enforcement until the appeals court has ruled on the second motion (which will probably be only a matter of weeks).

That motion must be based on yet another Apple proposal to MMI. And that proposal will almost certainly be the one that was discussed at the Friday trial involving the same FRAND patent but a different Apple legal entity.

Apple no longer reserves a challenge to the validity of the patent as a way to avoid liability for past infringement altogether. But as far as the determination of a FRAND royalty rate is concerned, Apple wants to remain free to raise any legal argument it can raise, including issues involving the (in)validity of an asserted patent or patent exhaustion.

At the Friday trial, the Mannheim court appeared to be primarily concerned about Apple's intent to reserve the right to use patent exhaustion as an argument in connection with the iPhone 4S. But Apple once again argued that a court making a future determination of a FRAND rate could still consider any of Apple's arguments unavailing, but Apple doesn't want to limit, through the language of the license agreement, its ability to argue what FRAND should amount to.

There was also quite some discussion about a scenario in which Apple's bond exceeds the royalty rate that a court may establish in the future to be the proper FRAND amount. I must admit that I was very surprised that this was an argument at all. In my view, Orange-Book-Standard clearly provides for the possibility of a bond in order to ensure that the patent holder will get paid, but if posting a bond wasn't meant to be a way to satisfy the Orange-Book-Standard criteria while avoiding a risk of overpaying, then that alternative wouldn't make much sense in the first place -- in that case, a company might as well just pay. I'd be surprised if the appeals court took issue with this, but it's hard to tell how the appeals court will rule on MMI's other objections, particularly the possibility of Apple's refusal to waive any arguments it might make in connection with the future determination of a FRAND royalty rate.

We'll see what the next step is. If the appeals court thinks Apple is more likely than not to have met the Orange-Book-Standard requirements with its new proposal, then it will suspend the enforcement of Motorola's December 9 injunction for the duration of the appellate proceedings. If, however, MMI raises objections to Apple's new motion that cast doubt on Apple's defense, then enforcement will resume -- but in that case, Apple could make MMI a new proposal and bring another motion to suspend enforcement.

On April 13, 2012 (that's a Friday the 13th), the Mannheim court will adjudicate MMI's assertion of two patents (the one based on which it already started to enforce, and the non-FRAND patent based on which it won another ruling two days ago) against Apple Inc., and with respect to the FRAND patent, Apple didn't raise any new issues other than its new licensing proposal. I guess the Mannheim court will see what the appeals court in its circuit now has to say, and will be quite likely to adopt the appeals court's stance on Apple's latest proposal.

While I've sometimes criticized Apple's tactical decisions (such as in its 2010 actions against HTC) and don't agree with those who essentially suggest that we should all have blind faith in the judgment of Apple's management and its lawyers, Apple's current way of dealing with MMI's FRAND assertions is the way to go.

Apple is obviously doing this to defend its rights and preserve its own shareholder value, but it is actually doing the industry at large a great service by fighting hard for more clarity on how the Orange-Book-Standard guidelines must be applied.

Furthermore, the fact that the European Commission opened formal investigations of Samsung's conduct shows that independent antitrust enforcers are concerned about injunctions based on standard-essential patents. Maybe Motorola and, possibly at a later stage, Samsung will hold German injunctions in their hands but refrain from enforcing them because of the antitrust issues those could raise at the EU level.

I have repeatedly highlighted the track record of MMI's lead counsel. But Apple's German litigators are also among the best of the best. MMI may have made pretty good choices in terms of which patents to enforce and where to sue -- and due to Orange-Book-Standard, Apple is fighting an uphill battle against standard-essential patents in Germany. Temporary sales bans appear more spectacular than they are impactful. Apple can always amend its proposals, and the latest one it made may already be sufficient under Orange-Book-Standard. If it's not, we'll see how far Apple will go -- and the more concessions Apple makes, the more MMI has to watch out for antitrust blowback.

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About Me

Florian Mueller is an app developer who used to be an award-winning intellectual property activist. His 30 years of software industry expertise span different market segments (games, education, productivity and infrastructure software), diverse business models, and technical and commercial areas of responsibility. In recent years, Florian advised a diversity of clients on the patent wars surrounding mobile devices, and on their economic and technical implications. (In order to avoid conflicts of interest, Florian does not hold or initiate transactions in any technology stocks or derivatives thereof, except that he is long AAPL.) He is now developing games for smartphones and tablet computers.